Light Versus Dark: ECNS and Dark Liquidity in FX

Much has been made of dark pools of liquidity in the equity market at present. These are financial markets not available or visible to the general public - essentially 'non-displayed' liquidity. They are a recent phenomenon in the equity market where lack of liquidity in a particular stock, especially a smaller issue, may be an obstacle for a fund manager seeking to enter or exit the market without adversely impacting the price. Choosing to execute within a dark liquidity pool where another participant may have the opposite interest, has the potential to reduce risk at a lower cost without alerting the market. In equities, transparency of time and sales data facilitates objective comparisons between the two execution styles.

While there are some initiatives in the FX market to create dark liquidity pools that mirror equities, there are concerns over whether they will succeed. Clear differences between the FX and equities market structures mean fewer participants have a problem transacting their trade size at the best rate and are willing to delay an immediate, guaranteed trade for the limited possibility of being filled in dark pool.

A large percentage of the foreign exchange market turnover is concentrated in a few dozen currency pairs that trade billions of dollars a day, which is in contrast to the thousands of single stocks in the equity universe of which only a few million dollars trade. The limited turnover of certain single stocks makes it hard to enter or exit positions and the narrow float can make borrowing them for delivery much more difficult than the overnight swap that is typically used to fund a position in foreign exchange. When taken together, this means liquidity in the largest currency pairs is significantly higher than with the typical equity and most participants can transact their full size at the top of book without paying any impact spread.

Players with positions that are larger than the one-pass liquidity of the market have typically used relationships with dealers to leverage their franchise order books as the preferred 'dark source of liquidity' to transact larger sizes. Dealers provide access to their books where client flow is internalized through both single-dealer and multi-dealer inquiry-driven systems, whose trading protocols ensure only the counterparties involved in the trade know about the potential buy/sell. In some cases where the two parties are disclosed to each other, deals are stuck at mid-market if both parties trust each other and reach a more desirable risk position. Positions of several billion dollars are frequently transacted instantly on these systems.

Only recently has price and sales information, a prerequisite for the growth of dark pools, become available, which would allow market participants to objectively analyze the relative benefit between ECNs dark pools. Further transaction cost analyzis that incorporates prevailing spreads for size on relationship trading systems will be necessary to draw any concrete conclusions.